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Measuring Operating Risk

Why Talk About Risk?

So far, we focused on maximizing contribution margin.
But business also involves risk, and managers must be aware of:

  1. Operating Risk – arises from fixed costs
  2. Financial Risk – arises from borrowing (interest payments)

Key Definitions

1. Operating Leverage (DOL)

  • Measures sensitivity of profit to sales volume changes
  • Formula:
    DOL = Contribution Margin / Profit Before Interest and Tax (PBIT)

High DOL = High fixed cost = High business risk

2. Financial Leverage (DFL)

  • Measures sensitivity of profit before tax (PBT) to interest
  • Formula:
    DFL = PBIT / PBT

3. Total Leverage

  • Overall business risk including both operating and financial risk
  • Formula:
    Total Leverage = DOL × DFL = Contribution / PBT

Case Study: Indian Hotels vs EI Hotels

Hotel Revenue (₹ Cr) Variable Cost (₹ Cr) Contribution (₹ Cr) Fixed Cost (₹ Cr) PBIT (₹ Cr) Interest (₹ Cr) PBT (₹ Cr)
Indian Hotels 1800 1300 500 200 300 150 150
EI Hotels 1100 660 440 247 193 139 54

Leverage Metrics

Metric Indian Hotels EI Hotels
DOL (Contribution ÷ PBIT) 1.67 2.28
DFL (PBIT ÷ PBT) 2.00 3.57
Total Leverage 3.33 8.15

What If Revenue Drops by 10%?

  • Variable cost drops 10%
  • Fixed cost stays the same
  • Apply DOL to estimate impact on PBIT:
Hotel Revenue Drop Estimated PBIT Drop (%)
Indian Hotels 10% 16.67%
EI Hotels 10% 22.80%

EI Hotels faces higher risk — more volatile profit due to higher leverage.

What If Revenue Rises by 10%?

  • EI Hotels will enjoy larger increase in profit than Indian Hotels.
  • High leverage magnifies both gains and losses.

Cost-Volume-Profit (CVP) Analysis

CVP: How Volume Affects Profit

  • Contribution Margin
  • Fixed Costs
  • Leverage metrics

Assumptions of CVP Analysis

  1. Revenue, VC, Contribution are constant/unit
  2. Fixed costs remain constant within a relevant range
  3. Mixed costs are separable into FC & VC
  4. Sales = Production (no inventory changes)
  5. No capacity additions during the period
  6. Sales mix remains constant in multi-product firms
  7. No inflation
  8. No changes in productivity or technology

⚠️ These assumptions often don’t hold in the real world, but CVP still offers valuable insights.

Takeaway

  • Understand the impact of fixed costs on profitability
  • Use DOL & DFL to measure risk
  • Use Total Leverage to plan for both downturns and growth
  • Always be aware of the limitations of CVP in real-world settings
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